Can You File Bankruptcy on IRS Debt? When You Can and Alternatives

Many people find themselves overwhelmed with debt, so if you are considering bankruptcy, you are not alone. Between medical bills, past due taxes, credit cards, and other forms of debt, it’s unfortunately very easy to end up with more debt than you can reasonably pay off. If you’re considering bankruptcy, it’s important to understand how the bankruptcy courts look at tax debt. 

This is a very complex area of bankruptcy law—taxes aren’t dischargeable in the same way that credit cards and medical bills are. You must meet specific requirements to have your taxes discharged in bankruptcy, which is why it’s important to work with a tax professional or bankruptcy lawyer as you explore your options.

Basics of Bankruptcy and IRS Debt

There are multiple bankruptcy chapters, and the option you choose depends on your income, how you want to handle your secured debt, and what is allowable under bankruptcy law. The three types of bankruptcy available to individuals are:

• Chapter 7: In Chapter 7 bankruptcy, a filer’s debts are discharged. Filers who exceed a certain amount of assets will have those assets seized and sold to pay back their creditors. Any qualifying debt that is not paid off after that will be discharged. Some taxes may be dischargeable in Chapter 7 bankruptcy, depending on how old the tax debt is and the type of taxes.
• Chapter 13: Chapter 13 bankruptcy is essentially a restructuring of your debt. Priority debts are paid first, along with secured debts. Unsecured debts are given the lowest priority, and at the end of the three-to-five-year repayment period, any unpaid unsecured debts are discharged. Tax debt is considered a priority debt in Chapter 13 bankruptcy. That means you will probably make payments on the taxes before they can be discharged.
• Chapter 11: Chapter 11 is usually used by businesses, but individuals whose debt exceeds the limit allowed in Chapter 13 may also file Chapter 11. Chapter 11 bankruptcy generally results in tax debts being paid off through debtor restructuring, rather than discharged.

Types of Tax Debts and Their Treatment in Bankruptcy

It’s important to recognize that the bankruptcy courts don’t just look at “tax debt” as a single type of debt. Within your tax debt, there may be income taxes, tax penalties, payroll taxes, and fraud penalties. These are each handled differently in bankruptcy:

• Income taxes: Income tax is the only type of tax that can be discharged in bankruptcy, and even then, there are significant limitations. Most recent income taxes cannot be discharged, and your debt must meet several requirements to qualify. We’ll discuss those in greater detail below.
• Payroll taxes: Payroll taxes are not dischargeable in any form of bankruptcy. They are also referred to as trust fund taxes, as they are the taxes that an employer must withhold from an employee’s paycheck to pass along to the government.
• Fraud penalties: Like trust fund taxes, fraud penalties cannot be discharged in bankruptcy. Your tax debt must have been lawfully acquired, and fraud clearly falls outside that definition.
• Tax penalties: Tax penalties, such as those associated with filing or paying late, can be discharged in bankruptcy depending on the year in which they were incurred.

Qualifying Conditions for Discharging IRS Debt

Once you’ve decided whether Chapter 7, 13, or 11 is the right choice for you, it’s time to figure out if your tax debt is dischargeable. There are three main numbers that come into play when determining whether or not your income tax is dischargeable.

First, there’s the three-year rule. The due date for the tax return that the tax debt came from must have been at least three years ago. This includes all extensions. So, imagine you want to file on April 14, 2024. Your 2020 taxes would have been due April 15, 2021. You would be one day short of meeting this requirement, so your 2020 taxes would not be dischargeable.

Some states also have a two-year rule. In cases where this rule applies, the tax return you filed for the tax debt in question must have been filed at least two years before your bankruptcy filing date. If you’re dealing with tax debt from a substitute for return, make sure that’s dischargeable under the rules in your state. Some states won’t allow you to discharge the tax debt unless you actually filed the return, thus SFR assessments don’t qualify.

Finally, there’s the 240-day rule. The IRS must have assessed the tax debt at least 240 days prior to your filing date.

Note that if you have multiple years of tax debt you want discharged, they are not considered one lump “tax debt.” Each year’s tax debt is considered its own separate debt and will be assessed accordingly by the bankruptcy court.

Even if you meet all of these requirements, your income tax may still not be discharged. If you engaged in tax fraud or tax evasion, it’s likely that your tax debt will stand even after your bankruptcy. You must have filed your returns honestly to qualify for discharge.

The Bankruptcy Filing Process for IRS Debt

When you decide to move forward with bankruptcy, it’s important to consult with a bankruptcy lawyer. The process of filing for bankruptcy is incredibly complex and full of specific requirements. Failing to meet one of these requirements or missing a deadline by even one day could put your entire case in danger. Bankruptcy is even more complex when you have tax debt, as the onus is on the filing party to prove that the tax debt qualifies for bankruptcy discharge.

The process starts with a full consultation, during which the attorney will look at your finances, including your debt, assets, and income. This is when they can tell you definitively whether or not your tax debt is dischargeable. Before filing, you will need to take a credit counseling course.

After you file, the automatic stay goes into effect. The automatic stay prevents creditors from pursuing collection activities against you, and even if your tax debt is not dischargeable, the stay applies to the IRS. This means the IRS cannot take collection actions against you, including levies, liens, asset seizure, and collection notices. The automatic stay remains in place until your debt is discharged, at which point the creditors cannot collect from you anymore, or until your case is dismissed, at which point they can resume collection activities.

You’ll need to attend a 341 meeting, also known as a meeting of creditors. Despite its name, creditors rarely attend these meetings. The trustee will ask you a series of questions, verify that the information you provided is correct, and clear up any ambiguities. If there are no further issues, you will receive your proof of discharge shortly afterward.

It is crucial to be completely open and honest with your attorney throughout this process. You must disclose all debts, sources of income, and assets. Those who fear they may not qualify for bankruptcy may attempt to downplay their income or hide valuable assets to ensure that they qualify. This is a good way to get your case dismissed and risk legal action against you. The bankruptcy court is very thorough in its investigation of bankruptcy cases, and anything you hide could lead to you keeping all of your debt.

Consequences of Filing Bankruptcy on IRS Debt

Part of preparing for bankruptcy is understanding how it will affect your finances, both in the immediate future and in the long run. Immediately after filing, you should expect to see your credit score drop significantly. This is normal and it is not permanent. With careful financial management and budgeting, you can rebuild your score over time. However, you may find it difficult to secure credit for some time after bankruptcy. You may need to rebuild with secured credit cards and other credit options specifically intended for those who have gone through bankruptcy.

Bankruptcy may affect future tax filings, depending on the timing of your filing. If you are owed a tax refund when you file for Chapter 7, you’ll need to talk to your attorney about whether or not you can protect it with one of your state’s exemptions. If you cannot, the trustee will seize the refund and use it to pay your creditors. Beyond that, your future tax filings will not be affected by your bankruptcy. You will need to file and pay on time every year to avoid future tax issues.

If you file for Chapter 13 bankruptcy, you will be in the bankruptcy process for three to five years. During this time, you will need to file your taxes on time every year and pay your taxes. Your trustee will look over your tax return each year to find out if your income has increased. If your income increases during your Chapter 13 bankruptcy, the trustee may request an increase in payments for the benefit of creditors. The trustee may also seize your tax refund in Chapter 13 bankruptcy if it is larger than usual. 

Note that a large tax refund may also lead to a full investigation of your finances, as it may indicate to the trustee that you have received a raise and are trying to hide the additional income by manipulating your withholdings. As is the case when you initially file bankruptcy, full disclosure is crucial throughout your repayment plan.

What about audits? Filing for bankruptcy does not protect you from an audit, but it also doesn’t guarantee that the IRS will audit you in the future. Your best bet is to file your tax returns honestly and on time every year.

Alternatives to Bankruptcy for Managing IRS Debt

There are other options you may want to consider if you aren’t quite ready to move forward with bankruptcy. These solutions deal specifically with your tax debt.

Installment Agreement

With an installment agreement, you can pay your tax debt over a period of 90 days, 180 days, or 72 months. The advantages of an installment agreement include avoiding the credit hit, legal and filing fees, and stress that come with bankruptcy. However, you do have to pay your tax debt plus interest in full, and missing even one payment could lead to the termination of your agreement.

Offer in Compromise

When you attempt an offer in compromise, you are telling the IRS what you can afford to pay to settle your debt. If your offer truly reflects what you are able to pay in your current financial situation, the IRS may accept it. This avoids the credit damage that bankruptcy causes while still allowing you to settle your tax debt for less than its total value. The downside is that there’s no guarantee that the IRS will accept your offer; you may want to work with a tax professional to ensure you put forward an offer that has a good chance of being accepted.

Currently Not Collectible Status

If you are in a dire financial situation that leaves you unable to pay anything that you owe the IRS, you may qualify for currently not collectible status. When the IRS places you on CNC status, it means they temporarily stop attempting to collect from you. However, interest continues to accrue and you are still responsible for what you owe. 

The IRS may periodically request financial documentation from you or they’ll just check your finances by looking at your tax return every year. Then, when they determine that you are able to begin making payments toward your tax debt, they will no longer consider you currently not collectible. The obvious disadvantage here is that you will eventually be expected to pay your tax debt back, and your bill will be higher due to interest.

The other obvious disadvantage to these solutions is that they do not have any effect on your other debt. If you have significant debt beyond your tax debt, bankruptcy may still be the most viable option for you.

Frequently Asked Questions

Can IRS debts be discharged through bankruptcy?

If your debt is from income taxes and it is old enough, it may be dischargeable in bankruptcy.

What are the requirements for discharging IRS debt in bankruptcy?

The debt must only be from income taxes. It must also be at least three years old, and the IRS must have assessed the tax debt 240 days before you filed. Some states have additional rules.

How does filing for bankruptcy affect IRS debt collection actions?

Filing for bankruptcy triggers the automatic stay, which prevents the IRS and other creditors from taking collection actions against you.

Are there any tax debts that cannot be discharged in bankruptcy?

Fraud penalties and payroll taxes cannot be discharged, nor can any income taxes that do not meet the requirements listed above.

What alternatives exist for managing IRS debt without filing for bankruptcy?

Depending on your circumstances, you may look into currently not collectible status, an offer in compromise, or an installment agreement.

How long after filing my tax returns can I file for bankruptcy to discharge IRS debt?

Generally, you must wait at least two years after filing a tax return, three years after the filing deadline, or 240 days after assessment to seek a discharge of that year’s tax debt.

What should I do if I’m considering bankruptcy as a solution for my IRS debt?

You may find it helpful to meet with both a tax professional and a bankruptcy attorney. You can learn about all of your options, as well as their pros and cons. This puts you in the best position to decide on the right choice for you.

When to Seek Professional Advice

In general, it is better to consult a bankruptcy attorney or tax professional sooner rather than later. If you wait until you are already in over your head, it is much harder for your attorney to help you. If you consult a professional as soon as you are struggling to understand your options or thinking you may be in trouble, they can explain your options and get you on track. 

Attempting a DIY approach to your tax problems may actually result in further issues. For example, if you begin filing for bankruptcy before thoroughly researching your options, you may accidentally file for a type of bankruptcy that you do not qualify for. That means you have to go through the trouble of refiling and paying all over again. Taking informed action is the best way to protect your financial future.

Ready to find out how you can manage your IRS tax debt? The team at W Tax Group is here to help. Just call us at 877-500-4930 or reach out online to set up a consultation.